Having one of your companies go into administration is an unpleasant experience, but theres not a lot shareholders or small creditors can do but sit back and wait.

The word ‘insolvency’ is one of the very dirtiest in the shareholder’s lexicon. And, if you’ve ever experienced one of your companies ‘going bust’, to use the vernacular, you’ve probably uttered a few other dirty words of your own. Sooner or later, most of us experience the sinking feeling of a company being placed into external administration. Here we’ll explain the administration process from a shareholders’ point of view, and conclude with what creditors can expect.

There are three main types of external administration, as you can see from Table 1. Perhaps the most common type now is voluntary administration – Timbercorp, for example, appointed voluntary administrators KordaMentha on 23 April. For our purposes we’ll use the term ‘administration’ as a general term for external management of a company in financial difficulties.

Why does administration occur?

You might wonder why a company’s directors would place it into administration. The reason is fairly simple. Under Australian law, it is a criminal offence for directors to allow a company to trade while insolvent. Once they believe their company will be unable to pay its debts when they fall due, their only course of action is to appoint external administrators.

Table 1: Main types of external administration

Receivership

Voluntary Administration

Liquidation

Definition

A secured creditor can appoint a receiver to take control of some or all of a company’s assets. If the receiver also manages the company’s affairs, they are called a ‘receiver and manager’.

Voluntary administration is designed to resolve a company’s future quickly. If the administrator can't save a company’s business, though, the idea is to manage its affairs to produce a better return for creditors than placing the company into liquidation.

Liquidation recognises that the business is not a going concern and that the company should be wound up.

Role of administrator

The receiver’s role is to sell enough assets to repay the debt owed to the secured creditor. The directors remain in charge, but their powers are limited.

The voluntary administrator takes complete control of the company’s affairs, and will recommend to creditors a plan for debt repayment (deed of company arrangement) or the appointment of a liquidator.

If creditors or shareholders vote for liquidation, the liquidator collects and sells the company’s assets and then applies for de-registration of the company.

Australian insolvency law is rather different to American bankruptcy law. You may have heard of US companies filing for ‘Chapter 11 bankruptcy protection’. A Chapter 11 filing allows the existing company management to remain in charge while re-organising the company’s affairs. During this period, the company is under the ‘protection’ of the court, which prevents creditors from collecting debts until a re-organisation plan is approved. It’s a very different approach which has some significant drawbacks, although the end result remains that creditors should get some return.

Down the plughole

Returning home, once a company enters administration, the most important thing to be aware of is that shareholders have almost certainly lost their money. During administration, the company will be managed by the administrator for the benefit of creditors. Shareholders have no say in the company’s direction and, in fact, there is generally no obligation on the administrator to report to them at all. In short, expect an ‘information vacuum’.

Many shareholders feel impotent, upset and downright aggrieved by this. After all, administration is the final and irrefutable proof of a poor investment, and there’s nothing you can do. It’s important to take away what lessons you can; but mentally ‘writing it off’ is essential for you to move on.

Some shareholders seek retribution or recompense through class actions and the like. Occasionally they’re successful and, in limited circumstances, shareholders have special rights*. But it’s important to remember that shareholders sit on the lowest rung of the corporate entitlement ladder. The price you pay for potentially unlimited returns is the risk of complete loss of capital.

Tax implications

Losing money hurts but unfortunately there’s salt to be rubbed into the wound. You can’t claim a loss for tax purposes straight away. You have to wait until the administrator makes an official written declaration that shareholders are unlikely to receive any further distribution in a winding up. In difficult administrations – Timbercorp’s Mark Korda warned ‘this administration is as complex as any we’ve done before’ – a declaration is probably years away.

Thankfully, there are two potential exceptions. First, you can sometimes sell your worthless shares to another entity to realise the loss. We’re aware of a website called www.delisted.com.au that buys shares in some delisted companies for a fee, although we cannot vouch for it and suggest you seek your own tax advice. Delisted.com.au is also a good place to find news about companies in administration.

Second, some companies eventually emerge from administration. Often, their new incarnation is more ugly duckling than beautiful swan, though, and shareholders usually find their holdings in the ‘new’ company diluted by significant capital raisings. But at least the re-listing allows shareholders to realise a tax loss. Just be prepared for a lengthy and frustrating process.

Recognising the signs

So it’s obviously best to avoid owning shares in a company that goes into administration in the first place. Let’s go back a step to see if we can recognise a few of the warning signs. Clearly, a lengthy and ongoing slide in the share price is the most obvious sign that something might be wrong. High debt levels are another early warning sign, as is the departure of key management or board members.

As a company approaches its final months and weeks, though, other red flags often begin waving vigorously. In Timbercorp’s 2008 annual report, the company noted that, in the absence of waivers, it would be in breach of banking covenants. Then, at its AGM, the company reiterated it had ‘restructured its borrowing arrangements with some of its lenders’, and that the company ‘plans to sell assets … to reduce debt’.

Whenever a company needs to sell assets to satisfy lenders, the situation is clearly critical. Once Timbercorp announced on 16 April that the sale process was unlikely to meet expectations, administration looked imminent. We downgraded to Sell on 17 Apr (Sell – $0.072), and the company appointed voluntary administrators a week later.

None of these red flags guarantee a company will go into administration, of course. The debt-loving Alesco, for example, looked in great danger until it managed to sell its best business last month. Together, though, red flags like these increase the risk significantly. But if management can pull an asset sale rabbit out of a heavily indebted hat, then the share price upside is enormous. Unfortunately, it wasn’t to be with Timbercorp.

What if you’re a creditor?

The situation for creditors, such as bondholders, is at least a little more positive. That’s because the task of an administrator is to manage or sell the assets to ensure creditors get the maximum return. What you’ll get depends on where you sit on the entitlement ladder, and how much the administrators can get for the assets.

Creditors who have security over a particular pool of assets are in the strongest position, but typically even they will take a haircut (that is, they’ll usually get back less than 100 cents on the dollar). As we noted in Timbercorp’s darkest hour, we expect holders of the TIMHB and TODHA securities to get at least part of their investment back eventually because the underlying security is property, water rights and agricultural assets.

Shortly after the appointment of voluntary administrators, the first meeting of creditors will be held. At this meeting, creditors elect committees to represent them, and the administrators outline their plans. Timbercorp’s first meeting was held on 5 May, when the administrators decided to suspend forestry and horticulture operations, and will now implement a plan for each individual project.

At the second meeting, creditors meet to decide the company’s future. At that meeting, a decision is made about whether to return control of the company to directors, to execute a deed of company arrangement (a binding agreement which sets out how creditors’ claims are to be paid), or to place the company into liquidation. The date for Timbercorp’s second meeting of creditors, as far as we are aware, hasn’t been announced yet.

No action needed

Unless you, as a creditor, want to participate in this process, you don’t need to do anything. The administrators are legally bound to work on your behalf to get the best return. Once again, though, the process is usually complicated, and you’ll probably feel like not much is happening after the initial meetings. This will particularly be the case with Timbercorp’s administration or eventual liquidation, which is likely to drag on for years.

Behind the scenes, though, the administrators will be working on your behalf. Keep your contact details up to date and sit back. As there’s not much you can do but wait, that patience you’ve been cultivating is about to come in very handy.

* In the High Court case Sons of Gwalia v Margaretic (2007), the court decided that shareholders could participate as creditors in a voluntary administration, but only if their loss had been caused by some misconduct of the company.

Australian Financial Services Number 282288.This publication is general in nature and does not take your personal situation into consideration.
You should seek financial advice specific to your situation before making any financial decision.Past performance is not a reliable indicator of future performance.We encourage you to think of investing as a long-term pursuit.